Insurance, Collars, and Other Strategies Chapter 3 Insurance, Collars, and Other Strategies

Basic Insurance Strategies Options can be Used to insure long positions (floors) Used to insure short positions (caps) Written against asset positions (selling insurance) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Insuring a Long Position: Floors A put option is combined with a position in the underlying asset Goal: to insure against a fall in the price of the underlying asset Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Insuring a Long Position: Floors (cont’d) Example: S&R index and a S&R put option with a strike price of $1,000 together Buying an asset and a put generates a position that looks like a call! Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Insuring a Short Position: Caps A call option is combined with a position in the underlying asset Goal: to insure against an increase in the price of the underlying asset (when one has a short position in that asset) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Insuring a Short Position: Caps (cont’d) Example: short-selling the S&R index and holding a S&R call option with a strike price of $1,000 An insured short position looks like a put! Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Selling Insurance For every insurance buyer there must be an insurance seller Strategies used to sell insurance Covered writing (option overwriting or selling a covered call) is writing an option when there is a corresponding long position in the underlying asset is called covered writing Naked writing is writing an option when the writer does not have a position in the asset Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Covered Writing: Covered Calls Example: holding the S&R index and writing a S&R call option with a strike price of $1,000 Writing a covered call generates the same profit as selling a put! Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Covered Writing: Covered Puts Example: shorting the S&R index and writing a S&R put option with a strike price of $1,000 Writing a covered put generates the same profit as writing a call! Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Synthetic Forwards A synthetic long forward contract Buying a call and selling a put on the same underlying asset, with each option having the same strike price and time to expiration Example: buy the $1,000- strike S&R call and sell the $1,000-strike S&R put, each with 6 months to expiration Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Synthetic Forwards (cont’d) Differences between a synthetic long forward contract and the actual forward The forward contract has a zero premium, while the synthetic forward requires that we pay the net option premium With the forward contract, we pay the forward price, while with the synthetic forward we pay the strike price Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Put-Call Parity The net cost of buying the index using options must equal the net cost of buying the index using a forward contract Call (K, t) – Put (K, t) = PV (F0,t – K) Call (K, t) and Put (K, t) denote the premiums of options with strike price K and time t until expiration, and PV (F0,t ) is the present value of the forward price This is one of the most important relations in options! Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Spreads and Collars An option spread is a position consisting of only calls or only puts, in which some options are purchased and some written Examples: bull spread, bear spread, box spread A collar is the purchase of a put option and the sale of a call option with a higher strike price, with both options having the same underlying asset and having the same expiration date Example: zero-cost collar Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Spreads A bull spread is a position, in which you buy a call and sell an otherwise identical call with a higher strike price It is a bet that the price of the underlying asset will increase Bull spreads can also be constructed using puts Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Spreads (cont’d) A bear spread is a position in which one sells a call and buys an otherwise identical call with a higher strike price A box spread is accomplished by using options to create a synthetic long forward at one price and a synthetic short forward at a different price A box spread is a means of borrowing or lending money: It has no stock price risk A ratio spread is constructed by buying m calls at one strike and selling n calls at a different strike, with all options having the same time to maturity and same underlying asset Ratio spreads can also be constructed using puts Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Collars A collar represents a bet that the price of the underlying asset will decrease and resembles a short forward A zero-cost collar can be created when the premiums of the call and put exactly offset one another Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Speculating on Volatility Options can be used to create positions that a nondirectional with respect to the underlying asset Examples Straddles Strangles Butterfly spreads Who would use nondirectional positions? Investors who do not care whether the stock goes up or down, but only how much it moves, i.e., who speculate on volatility Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Straddles Buying a call and a put with the same strike price and time to expiration A straddle is a bet that volatility will be high relative to the market’s assessment Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Strangles Buying an out-of-the-money call and put with the same time to expiration A strangle can be used to reduce the high premium cost, associated with a straddle Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Written Straddles Selling a call and put with the same strike price and time to maturity Unlike a purchased straddle, a written straddle is a bet that volatility will be low relative to the market’s assessment Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Butterfly Spreads Write a straddle + add a strangle = insured written straddle A butterfly spread insures against large losses on a straddle Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Asymmetric Butterfly Spreads Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Summary of Various Strategies Different positions, same outcome Strategies driven by the view of the market’s direction Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved.